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Formal economics used to be almost entirely devoted to issues of the allocation of scarce resources. A subset of inquires, usually called welfare economics, frequently explored how different allocative schemes affected economic welfare. Welfare, however, had a rather arcane meaning in formal economics because inter-personal comparisons were generally frowned upon in formal theory and applications. To get around the “dryness,” of such studies, economists adopted a compensation principle where by if at least one person was made better off and none worse off, then welfare was improved. This skirted the issue of “fairness,” or as some wrote about it, of “justice.” What if compensation by the winners was not paid to the losers after an economic policy change? A mere glance at today’s media tells us that issues of “fairness” rule the day, almost to the exclusion of discussions of efficiency. Social change is often motivated by issues of fairness and politicians of every stripe place fairness at the top of their choice menu. But, what is fair to one person, clearly could be unfair to another. Moreover, the achievement of “fairness,” brings with it economic costs. The latter are often ignored, but the consequences should not be. To truly be fair, we need to evaluate the cost of achieving fairness, however it is defined. This is the first of a series of notes that discuss aspects of the linkage between fairness and efficiency in political economy.

At a time when many fed-up voters in the UK seem to want to get out of the EU, it seems appropriate to use a Churchill quote to describe the utterly dependent nature that our Federal Reserve has chosen to acquire. Yes, we have a nominally independent Central Bank—that is to say that once the politicos have nominated and approved a member of the Board of Governors, they technically vow to keep their “hands off.” Of course, neither really allow a Fed to be independent, and it is hard to say that the shrill voices from 1600 or the Hill have no affect on the voting behavior of Governors. Who really knows how the Board comes to its conclusions? If you still think the FOMC is independent, ask the Regulatory wing of the Fed if it operates as a deaf mute!

That said, 50 years ago or so, the talk in US monetary policy debates among academicians and central bankers who seemingly agreed that a Central Bank had to be politically independent and should make its decisions based on the fulfillment of whatever chartering mandate it was given. Is it not strange, therefore, that the current FOMC finds that “international considerations” have now paralyzed its rate-making decisions? After a feeble 25 basis point (“bp”) raise in December, the FOMC has staggered and stuttered, looking around the world at what other enfeebled CBs are doing and has paused and paused and paused. Talk about ‘waiting for Godot.” Meanwhile, rate-starved fixed income holders now have the privilege of paying their respective governments in Germany and Japan for the privilege of making their savings available over the next decade. Nearly nothing for the insurance in Germany (3 bps) but 8 bps in Japan, a far cry from holding government bonds as a default-risk free investment with a nominal positive yield. Surely, they would have been better this year to buy Gold and stick it in a bank vault!

Meanwhile, for a Fed now fully engaged in the regulation of bank balance sheets in order to root out (still undefined) “systemic risk,” what has happened to independent monetary policies? The answer is quite simple. They no longer exist—and returns to Americans who wish to invest in default-risk free 10 year Govies are shrinking as well.

Oh, well—why not throw out everything we ever learned about monetary theory and policy? If such policies don’t work (according to the Fed), there’s no point holding on to them, is there? One might ask to be shown the theory that has replaced older thinking on monetary policy, but it is to be doubted that the question would even be heard in the board room at the Fed. It doesn’t seem like they have a theory that governs their policy making. Maybe they are too busy telling each other how they are preventing systematic risk via their new “stress tests.”

Well, why should central banking be any different from Health Care, Internet policing, Environment Protection, and Pharma Controls? We have entered the Grand Regulatory State—no point studying Macro anymore…it is irrelevant because the Fed is a totally Dependent Creature—as are we all in this highly regulated political environment. We must speak correctly, we must invest correctly, we must be correct on our identification of the soldiers of terror. We are all now quite correct, are we not? A riddle? Yes. A Mystery? Yes.

Mr. Prime Minister: we need an Enigma Machine to read the Fed’s Code. Please re-open Bletchley Park and start cracking it for us.

The troubling antics of the remaining three contenders for each party’s Presidential nomination have forced me to detour from postings on Ecomentary.com far too long. Governance issues have been capturing my full attention. Let’s direct some comments to their economic policy recommendations.

Each candidate speaks of doing something for those who feel underserved or even left out of the economic benefits our economy creates. Their substantive proposals amount to two sorts of “cures.” One is to blame someone or a class of “someones” for poor economic outcomes and the other is a continuing advocacy of ‘once size fits all’ remedies—more government intervention. Actually, all three wish to use the government to “do something,” with little or no recognition that government interference is not costless to economic growth. On the contrary, increased regulation has undoubtedly contributed significantly to lower economic growth. A smaller pie, even if redistributed, is not a winning economic strategy.

The two Democrats, Clinton andSanders both argue for more government intervention, more regulation and heavier taxation (albeit more “progressive”). Trump also argues for government intervention. He wants to punish the Chinese and other “foreigners” for American job losses. He even wants to punish American firms who relocate production overseas. Traditional Republican support for free trade has been eviscerated, free traders have little to choose between the two parties. Restricting trade is a sure fire method to reduce growth.

One expects Democrats to try slicing up the economic pie and redistributing it to pay off the various political minorities and interest groups that Democrats depend upon to win public office. By assigning much of the blame for the 2007-2008 financial meltdown to greedy bankers, evil mortgage companies and mortgage brokers and other profit seeking financial intermediaries, Democrats don’t look deeply, if at all, into the role played by much faulted government housing policies. They continually advocate more regulation, not less. Meanwhile, instead of attacking the increased interference and regulation that deters the formation of new business enterprises, the Trump response is that voters need to pick a Winner instead of sticking with Democratic losers. Is that a policy prescription or a denial of how the economy actually works?

Neither side seems to understand that government intervention and regulation does not offer a free lunch. They seem totally unaware that the already well-laden Regulatory State costs the US substantial economic growth. Obama always argued that the US needed to become more like Europe. He succeeded beyond all measure. The US has more regulation and lower growth. Welcome to Europe, voters!

Of course, if you think that the economic pie has been distributed “unfairly,” you probably don’t focus on how to bake a larger pie. You might not even think that regulation can affect how fast the economy grows. Former President Reagan’s remark that “Government is not the solution; Government is the problem,” has long since been forgotten, even by some claiming to be market- oriented Republicans.

In recent years, however, a number of economists have been focusing on the costs of regulation and how regulation can slow and undoubtedly has slowed U.S. economic growth. When the question is, How much does a reduction in annual growth of say 1% per year actually cost the US, when that reduction continues over say a thirty five year period, the cost is staggering. A bigger pie was available, but increased regulation destroyed a much better outcome.

A recent study published on the Mercatus.org web site (“The Cumulative Cost of Regulations,” by economists Bentley Coffey, Patrick McLaughlin, and Pietro Peretto) provides some insight. They estimate US economic growth was lowered by 0.8% per annum as a result increased regulation. Putting it more graphically, they find our economy would be 25% larger today than it actually is —-even if the costs per annum were as small as 0.8% per year. We conjecture that the annual costs might well exceed 1%.

There are many studies that show that the current level of reporting now required under environmental, health care and labor regulations pose a heavy cost burden for new, small businesses. New business formation lags in spite of very low interest rates. Yet, it is widely understood that real economic growth comes from precisely this segment of the economy. It is also well noted, but yet unexplained, that business investment in plant and equipment has been unpredictably sluggish. Perhaps, our declining productivity trends are not just accidents due to “slower innovation.”

These are subtle arguments but none of the candidates care or perhaps are even aware of them. They have missed the truism that a little hole in the dike can be as bad as a large one, given sufficient time. Time makes water a very powerful cumulative force. Similarly, even small decreases in annual economic growth can cumulate to a very large reduction in actual output. Increasing regulation works the same way and the US economy is badly under achieving.

It will be hard to punish the “foreigner” for our own failings. Punishing our own business sector can only worsen the problem of inadequate growth. The first step in getting well must be a proper diagnosis of our growth disease. We become our own worst enemy when we listen to the Siren calls for more regulation by the current candidates.

The other day, a non-economist friend asked me about Janet Yellen’s husband [George Akerlof] and I was dragooned into explaining what his famous “Lemons” paper was all about.1 Then Jason Zweig of the Wall Street Journal published his interview with Ackerlof and Shiller again raising the issue of asymmetric information.2 Here is a re-think of some of the fundamentals raised by the notion of poorly informed market participants: the Phools who are Phished by competitive markets.

I missed the first edition (1970) of the Lemons paper as I had already left organized economics for the business world. In thinking about Macro most of this summer at my fire-surrounded California home, I have been focusing on what is “left out” of conventional macroeconomics. I chanced this morning to see Zweig’s note in the WSJ about Akerlof and Shiller (my former student) telling us that competition produces thievery and questionable products offered by “tricksters.” The timing of the interview, coming after the incredible disclosure by Volkswagen that it had tampered with the results of EPA pollution tests on its diesel cars underscored the “trickster” nomenclature. Score one for Zweig’s timing. Still, the underlying critique of competitive markets is a long-standing thread among social reformers and also has its place within the economics profession. The Lemons paper is part of that thread. The issue is the relevance of that model for consumer well being.

I don’t remember Adam Smith or Milton Friedman or George Stigler telling us that competition abolished all the less desirable traits of humankind. I thought their message was that the social good was promoted in spite of the knavery of the butcher, the baker and the candlestick maker. I don’t believe that the Wealth of Nations pretends to be the description of the perfect society—perfect in the sense of the much-desired Kingdom of God. Nor has the constant rant against competitive capitalism produced a demonstrably clear alternative that has stood the test of time. The absence of a demonstrated alternative must then mean that we must evaluate the success of competitive markets not as an abstraction but as a comparison to other likely systems of organizing economic activity.

Moreover, I thought the central theme of many writers since Smith was that the motives of individual market participants are to a large extent not relevant in creating a plentiful supply of goods and services that are efficiently priced. Of course, it is the word “efficiency” in the last sentence that sets the roosters to crowing that something new is feeding in the barnyard. Did Smith leave out Phools and Phishers now current in behavioral models of human action? Must we now pay close attention to such individual behavior in order to evaluate competitive market outcomes? Let me back up a bit.

Having been asked to explain the Lemons concept, I did so, but I wanted to be sure I got the essence correct. This morning, I decided to check if I had rendered the Lemons story properly in lay terms, and went back to look up the famed Ackerlof paper. I didn’t have the time to read through the original piece. Instead I skimmed the Wikipedia summary for its central finding: using the Used Car Market as the example, the contention was that the “peaches” are driven from the market, meaning that the market only consists of lemons!

Admittedly, the asymmetric information model has always bothered me—e.g. the small businessman gets an “inferior” loan deal because the banker knows less about the potential borrowers’ true state. Why? I was a small businessman and I borrowed. Was I then a Phool? Did I get taken-in by my Phisher banker, or did I search for the best deal I could find considering my own idiosyncratic circumstances? Did my banker trick me into accepting an inferior loan? Back up to the Lemon’s truck. Presumably a rational businessman checks the credit opportunities open to him. He chooses from the alternatives open at the time. It could be a Lemon, a Peach or a Prune.

What happens to the peaches in the market for lemons? They must be piling up somewhere in the universe—like the third order of smalls we keep throwing away in most empirical studies. (I always feared that the Kingdom of the delta squares and the delta cubes would somehow bring the entire universe down on our heads. Conservation of matter must have mean something. Maybe it will be a squishy with peaches instead of raindrops falling on our heads?

What struck me this morning as I feared to look at the market smashing my paper wealth to smithereens was that Wikipedia never said anything about what happened to the peaches except they were driven from the market.

Where did they go? I mooted the possibility that there were so few Peaches on the used car lots of America that the intrepid used car salesmen themselves drove them home instead of selling them off to customers. But clearly, lemons to peaches is some sort of a quality continuum. However many cars are sold annually on the used car market, I have never seen a special lot where only Peaches are sold, nor do I assume that every used car lot consists only of Lemons waiting for a Phool. Am I wrong? Maybe all of the last two decades of specialized car lots that warrant everything but the VW diesel’s actual pollution emissions, are filled only with Lemons (that of course may now change)? How can that be? One answer is an undersupply of smart used car salesmen. Somehow, that is not a satisfying answer. Something is left out of the original characterization of how the used car market works.

Moreover, as I thought about the Lemons problem, I was reminded of the similarity of standard Chicago stock-flow problem that Milton Friedman used to ask us to solve. Think about it. The market in question is for used cars—and let us ignore the fact that a used car, even a Lemon, represents a household capital item. For now, just focus on the flow market for used cars.

The cars start off largely in an auction market where new car dealers are shedding the trade-ins that they deem unlikely to sell themselves. The Used Car Mavens at the auctions rip that market apart, pricing Peaches and Lemons appropriately. The New Car Sellers have some knowledge of the value of a vehicle (whether it is Peach, a Lemon or some other kind of fruit) and their objective is to clear their own lots. (I guess they hold back some of the Peaches themselves—but if that is true the entire structure of the Lemons theory kind of falls apart). So let’s just say, be it a Lemon, a dried up Prune or a fresh, firm juicy Peach, they all show up at the auction and the omnivorous Used Car tribe devours each of them at whatever price they can get away with.

For a trade to occur, there must be a willing seller and a willing buyer—both somewhat knowledgeable—although in this case the Used Car tribe must be at somewhat of a disadvantage themselves, since they have but a short time to inspect the available vehicles which represent only the ones the new car dealers don’t wish to carry on their own lots. Still, the market clears.

Now, the collage of fruit shows up on the Used Car Lots of America. Fearful buyers (the Phools) begin to shop, in terror that they will be stuck with a Lemon. According to the original version of the theory, the Peaches have disappeared. Competitive equilibrium thus leaves us with a highly inferior outcome. Only the Lemons survive!

That’s what still bothers me. We are purportedly measuring a flow demand curve and supply curve, but the observed supply curve is missing all the Peaches. How can that be a sustainable equilibrium? The theory says that the actual price paid is some sort of a combination of Peach and Lemon prices—but then the Peaches go somewhere—and all that is left are Lemons. This is clearly an incomplete characterization of how the used car market works today. I doubt it worked that way in 1970.

The Lemons theory without an adequate specification of true stock-flow equilibrium, throws a spanner into the works. The model is incomplete in a crucial way and welfare implications drawn from such a model are likely to be highly suspect in the best case, totally erroneous in the worst case.

The Lemons problem, structured as it was in those days, was a kind of incomplete game. Yet, a flow market is clearly a repetitive game in which learning must be taking place on both sides of the market. Suppliers gather information from yesterday’s outcome and buyers learn about faulty transmissions dropping out of their neighbor’s used cars. Thus, any inference drawn from the actual observed prices of used cars must somehow incorporate that prior learning which goes on day by day. Indeed, that explains the evolution of the Used Car Market today—a huge change from the mid 1960’s. Now reputational capital supplied by national used car dealers—public companies now as well—is involved in an efficient pricing game, with warranties and ‘take back’ policies available to a complaining Lemon buyer. And, as far as I can tell, the stock of Used Cars doesn’t have a special lot only for Peaches either.

Dynamic Stock Flow equilibrium seems to sharply weaken the asymmetry case. Learning behavior is absolutely critical to understanding the behavior of market participants. Yesterday’s Lemons are not just thrown away. Somehow, they get incorporated into the pricing of currently available used cars. Their values rise and fall upon much more comprehensive knowledge about the performance of various models and makes and vintages. Dealers who specialize in selling Lemons to Unwitting Buyers must achieve something of a reputational equilibrium as well. Why would we think the Buyers who talk among themselves over time, so to speak, don’t know which dealers have better fruit and what the price of damaged fruit ought to be?

Still, however, we get the assertions from very learned and honored economists who claim the competitive model leads to flourishing thieves who prosper while Phools suffer. No one seems to learn. Common sense tells us that the market is made up of both—and all the rest of us in between.

Yet, pricing for quality works itself out. Better quality goods get better prices over time than poorer quality goods, while one can always find both kinds of fruit in any market. Cheap imitations of first quality goods sell for significantly lower prices. How is that possible? And how is it possible that new suppliers of varied quality enter markets with questionable quality goods—only to be sorted out by repetitive buying and selling? Apparently, even Phoolish buyers get to taste the fruit from time to time. Learning is essential in all markets over time. Nothing surprising here.

Under most conditions, the second golfer on the green, who puts last, has more information than the first to put. Learning by doing and reputational capital are permanent fixtures of all efficient markets. Otherwise, we would never get anything like an approximation to stock-flow equilibrium. Confusing an individual action and long-term market equilibrium is excusable for non-economists. Should it be for Nobel Prize winners?

PT Barnum was right, partially. A sucker is born every minute and by definition Suckers lose money. Others learn, however from those unfortunate outcomes. Over time, some of those suckers learn from their earlier mistakes and other market participants learn as well. The story doesn’t end here. The issue of who’s the fish, the sucker in the game is relevant. Are there other ways to organize trade and production that would alleviate this problem?

We need to ask, what alternatives are there to providing adequate information to markets filled with Phools and Phishers? The Government? Regulations? Here comes the Saint of non-market solutions. As far as I can tell from many years dealing with many governments in many countries, government gets its share of Phools as well. Worse, the compelling power of Law and Regulation often enshrines faulty views that are hard to extract from the regulatory complex. Furthermore, any given set of new regulations will send signals to market participants to find a work-around. The “regs” themselves set up a system of rewards and punishments that create incentives for “bad” and “good” behavior. In a public market context, this means that complex public companies have a manifold set of departments whose employees will be given inherently conflicting goals: “keep the product priced so we can sell it,” “expand output so that we can maximize profits,” and “stay within the regulations.” These are very complex instructions involving lots of tradeoffs between the letter of the law and the compensation available for those who don’t get caught.

Since we now tend to pay employees who produce the best results, we create incentives to find a “work-around ” within any given regulatory structure. Markets also tend to create larger and larger enterprises because of supposed economies of scale and scope. This leads to a complex set of organizations whose activities fall into “silos.” We then expect our senior executives and the Boards that supposedly supervise those managers to maximize shareholder value and stay out of trouble, presumably by looking down each silo to see what is going on all the way down. That creates a never-ending scenario of risk and return within which the various activities of a corporation get organized under a common capital base. Unavoidably, “solutions” occur that appear to solve the problem yet bury the inherent risk. A shock occurs and the risk certainly appears and we ask, “How did that happen?” Even a scrupulous honest senior manager cannot just look down into the silos and spot all deviations from “best practices.” We then get a “London Whale” or the “VW Fraud”—not for every enterprise, but for enough to keep journalists well paid to investigate possible If the final outcome were only entertaining investigative journalism that discloses what is not clearly obvious to market participants, the outcome would be tolerable. Sadly, we get more. Some are so offended that they go to the Government to regulate and get rid of the apparent problem recently disclosed. Some regulations do improve market performance. But, if we expect the Government regulators and legislators to be totally observant of the advice given by Caesar when he divorced Pompeia, who are the Phools?

PT Barnum was right…but the real suckers are those that believe that by saying Government or more regulations will solve such problems efficiently or in a timely manner. The evidence is in. Even regulation doesn’t avoid Lemons, even if changes where they appear.

During the Bernanke era, the FOMC made strides to create more transparency about the intended course of monetary policy. This was done with the view that monetary policy changes should be better understood by the public (the markets), and that this understanding would give both transparency of Fed actions but also that monetary policy itself would be more effective by making that policy more transparent.

In fact, the so-called “Woodford Doctrine,” elucidated at an earlier Jackson Hole conference (August, 2012), seemed to imply that the Fed actually possessed an additional weapon in its tool arsenal by communicating its long run policy guidelines. Woodford, of course, had advocated a simpler guideline, nominal GDP, to avoid potential situations of conflict between the explicit dual mandate of output and inflation. Woodford felt sticking to the guidelines was a powerful weapon for the Fed.

Given the dual mandate of output (employment?) and inflation, Woodford’s prescription should have given the Fed a kind of channel within which the Fed could and should operate. He did allow for the ambiguity of potential conflict between the two targets but long term guidance was not to be disturbed without clear indication that something very fundamental had changed: No surprises; clear intentions: longer run predictability of actions. Who really could argue with that?

Rumor has it that the ”adult at the party,” was less clearly disposed to accept this as a guidance criterion for the Fed. Fischer’s approach at Jackson Hole 2016 (See Ecomentary.com “Off the Table-On the Table: the Fischerine Query,” August 31 2015) seemed to imply that no firm channel existed or was even desirable. Some critics of Fed policy could note that the dual mandate criteria might well be insufficient as a guideline of Fed future policy. It appears to this observer that Fischer has had his way at the FOMC meeting of September 17, and the ambiguous statement of policy intentions contained in the Yellen Press Conference following the FOMC meeting that day is now the name of the game.

The press conference walked away from the dual mandate criteria and introduced external economic conditions as a compelling reason for the Fed to “wait a bit longer” before implementing its first dose of a return to monetary policy normalcy. It is to be noted that only a solitary dissent by District bank President Jeff Lacker accompanied the decision. To this observer the title of “adult at the party” has changed hats!

Bernanke’s view of transparency to which the market thought Yellen had subscribed was that abrupt and uncommunicated policy shifts were nugatory at best, damaging at worst and clearly not effective forward policy guidance. While Bernanke didn’t subscribe to an iron-clad rule (such as one of the versions of John Taylor’s rule or Milton Friedman’s percentage growth rule) it seemed reasonably clear that long term guidance for Bernanke implied the use of the same criteria for FOMC policy shifts, meeting to meeting unless something extraordinary had occurred. Bernanke didn’t exclude the possibility of discretionary actions from its long-term guidance—in the event of striking and unexpected developments in the economy—but it was clearly an attempt by Bernanke to place a bridle on a potentially bucking horse in monetary policy decisions. Where a decisive change in policy had to be installed, it would be in the context of full public pronouncements that the rules of the game had changed from a sharp and unexpected shift in economic conditions. Now comes the Yellen-Fischer concern with American financial policy in light of world developments that were widely known well before the FOMC met on September 16-17.

What’s gone wrong here? First, all of the reasons that Yellen cited for her “patience” policy had long been in the market. China, emerging market fragility, poor growth in Europe were not new conditions. They had been talked about at Jackson Hole and by market observers for many, many months. Meanwhile, the unemployment rate—with all of its weakness as a measure of labor market conditions—was steadily declining; and, Yellen herself had spoken of her wish to view labor market conditions in a larger perspective. As for inflation, the FOMC had said and continued to say that despite very recent deterioration from the 2% criterion, it fully expected prices “in the medium term” to rise up to the 2% target.

While various market reporters had signaled only a 50% probability as to the likelihood of a Fed rate increase, the reaction of equity and bond markets was one of shock. Clearly, the public as a whole had been conditioned to expect that the ‘return to normalcy’ was about to begin. The S&P fell sharply following the widely expected “return,” and world wide markets (closed at the time of the announcement on the 17th) rattled down decisively the next day. Anytime the Fed thinks that world wide conditions are very frail, the market is bound to think the Fed knows something that the market doesn’t know. Could it be that the FOMC with all of its expertise and adults at the party doesn’t know the impact of disappointed expectations? Does the FOMC think that equity markets are a bubble that needs pricking?

What Yellen accomplished at the FOMC meeting and subsequent press conference seemed to violate the long-standing transparency rules that the Fed once had! To put it differently, it was a MISCOMMUNICATION, and that is a polite description.

A more sober assessment is that the market can no longer take the Fed as following its previous communications policy. This Fed is not transparent. It has undermined any credibility that the Bernanke era gave it. The Bernanke rule was really the following: set a course (for the Central Bank); stay on the course in order to anchor expectations in the financial market; deviate only if extraordinary events begin to change that have threatened financial stability. It was a “rule by exception, and the exceptions should be few!

Nothing major has occurred either overseas or in the U.S. except the perpetuation of known trends. Therefore, the market’s expectation of a first rise in the target rate coupled to a trajectory of very slow normalization was “in the game.” The Fed changed its rules. It has miscommunicated. By doing so it may have dislodged its carefully placed anchor.

Investors beware. We are back to a pre-Bernanke Fed—to a world of possible, unexpected shifts in policy. Build more uncertainty into your market forecasts. The Fed has told you to expect less forward guidance that can be relied upon and more (whimsical?) policy making under the guise that the “U.S. is not an island.” We are back to the Greenspan days with its mumbled pronouncements.

Jackson Hole Themes and the September FOMC Meeting: is the rate change on or off the table? MAS 8 31 15

It is hard to overemphasize how large the media focus is on predicting whether the FOMC will raise rates at its September. With that backdrop, surely observers at Jackson Hole gave rapt attention to the speech by the Board’s Vice Chairman, Stanley Fischer. Given his well-regarded academic achievements, his tours of duty at the IMF and the Bank of Israel, plus his sojourn at Citibank, outsiders regard his remarks as significant —potential containing clues as to the thinking at the FOMC. Perhaps, both hawks and doves in that birdcage listen more intently to a Fischer squawk than to others, while outsiders often refer to him as the “adult” at the table. Clearly there was wide interest at any hints Fischer’s speech might produce regarding what the Committee is thinking and what it ought to think about in its rate-setting deliberations next month. The speech is a sober recital of the complexities of gauging where on the projection screen of employment and prices the US economy is at this moment. It is unlikely that it ignited any new conclusions. It was a temperate and thorough discussion on the difficulties of judging the future course of inflation, and how close the Fed might think it is in achieving its stated 2% objective. The speech also did not ignore the importance employment in evaluating the twin mandate, but it put a larger context around the usual focus on the unemployment rate by mentioning the status of older workers, part-time employment as well as the labor participation rate. His careful deliberation on the back of a tumultuous two weeks in equity and exchange rate markets all around the world underlies the Fed’s awareness that US rate changes affect other countries in the world economy. Here is what we view as his important points regarding inflation. focused on judging how close current inflation is to the 2% target while emphasizing that concerns should be on the forward path of the inflation rate.

pointed to how close to zero are the changes in the measured inflation rate despite the substantial oil shock.

Observed that the lack of upward changes in prices is only partly explained by issues of slack

Core inflation can be influenced somewhat by oil prices but the larger effect comes from dollar appreciation in terms of expectations and pass-through to GDP growth

Changes in dollar value: the estimated pass-through from import prices to consumer prices occurs relatively quickly within a quarter and the bulk of the overall effect occurs within one year

The effect of dollar appreciation with regard to GDP occurs over a longer time period, and …”it is plausible to think that the rise in the dollar over the past year would restrain growth of real GDP through 2016 and perhaps into 2017.

comment: Fischer doesn’t discuss why it is then if dollar appreciation works to slow GDP, shouldn’t we see that in the labor market? That is not happening so far.

The dynamics of inflation depend upon changes in expectations and expectations have been remarkably stable. Consequently, he sees stable inflation expectations as a dampening force in transmitting exchange rate changes to prices in the US economy.

The relevance of the above is that the FOMC has to assess progress—both realized and expected—toward its 2% objective. The Committee anticipates that it will be appropriate to raise the target range…when it has seen some further improvement in the labor market and it is reasonably confident that inflation will move back to its 2% objective over the medium term.

Fischer highlights the coming Employment Report due Sept 4, but the FOMC’s reaction won’t be a “mechanical one”

The FOMC will also be interested in unemployment of older workers, workers working only part-time for economic reason and the participation rate

Furthermore, FOMC will look prices in terms of the CORE inflation rate. (Here, the interest is whether the movements in the CORE rate give better forecasts of the future inflation rate)

The FOMC is also interested to decipher where the US economy is going, rather than where it has been. (It almost seems like he wishes to disconnect the FOMC from the revised 3.7% real growth rate of the Q2

At this point, the FOMC will also be looking at the effects of a target rate increase on economic activity outside of the USA.

1) Monetary policy has two goals: maximum employment and stable inflation. Policy at any moment of time requires the assessment of where the economy is and where it is likely to go. That assessment is clouded by the inability to specify how much unemployment is cyclical and how much is structural. If the former, possibly it can be treated with monetary policy instruments. If the latter, it is beyond the Fed’s reach. 2) The inflation target has essentially been reached but the Chairwoman, still thinks there is “slack” in the labor market. She concedes that the differentiation between cyclical and structural unemployment is hard to make, but looking at the plethora of indicators in the labor market, she feels that the current level of (monetary) accommodation, is appropriate, particularly in view of the scheduled run off of central bank purchasing of Treasuries and MBS. 3. The difficulty with this assessment is that judging labor market conditions is at best extremely difficult. Forecasting how a continuation of the current policy target will affect labor markets in the future may beyond the Fed’s capability. Certainly, no single labor statistic is sufficient while how to mix them for maximum forecasting is not without controversy. She hints at the research going on within the Fed on a ‘factor’ analysis, but that will not convince markets in the short run 4. Fed guidance in such circumstances is unclear. Worse, using a potpourri of labor market stats will probably confuse markets more than it will enlighten them. Sometimes too much information overpowers common sense. 5. Ad Hoc tinkering or policy rules? At the end of the day, the larger issue of whether to base future policy on statistical babble or to adhere to a well understood policy rule is not treated in this speech. This Fed continually runs away from establishing a clear rule—one that markets might be able to discern Markets will glean little from this speech. Equity and fixed income markets will continue to oscillate in the absence of clear central bank guidance and the troubling geopolitical events of the day.

What went wrong? The causes of the financial meltdown of 2007-9 continue to be researched and debated by macro economists and financial analysts. It is likely to be years before a definitive analysis becomes widely accepted. Despite that debate, at least one antecedent to that disaster is present in nearly all explanations: government policy measures over many years to expand subsidies to owner occupied housing for poorer Americans were plagued by faulty incentives.

These incentives had very malign consequences for the financial sector of our economy. Under appreciated risks arising from poorly documented mortgage applications grew prodigiously. Mortgage companies were incented to write mortgages for individuals who could neither afford their ultimate financial obligations nor often understand them. Wholesale funding of such faulted mortgages received huge support from monetary policies that promoted world-wide yield searching. Credit rating agencies were suborned by the profitability of creating triple-A credit ratings for mortgage backed securities. Regulations that required many institutional investors to buy only securities with triple-A ratings created disastrous portfolio incentives. GSE’s were incented to expand their guarantees of subprime and Alt-A mortgage paper. Without question, short run political objectives overran prudential common sense.

It’s baaack… Thoughtful observers of American political economy should be alarmed how the politics of subsidizing the “poor” to acquire housing is ‘back in the game.’ While no one has demonstrated that weak mortgage underwriting standards truly work to reduce long term poverty, appearing to make more credit available to individuals and families that they may not be able to support has undeniable voter appeal. Politicians operate on a short run electoral cycle. Faulty incentives are ignored or buried under political rhetoric.

In the aftermath of the financial panic, tightened standards on mortgage underwriting were the order of the day in 2011. Regulators insisted on a minimum of a 20% down payment or lenders had to retain a minimum of 5% of the loan if the loan was resold to investors. Prior neglect of such incentives had resulted in a serious financial disaster. It appeared that policy makers were moving in the right direction by focusing on inappropriate incentives for poor financial behavior. Sadly, this reform diet has now proven to be too strict for politicians who observe what appears to be an inadequate restoration of the housing sector. The result is bad incentives for mortgage underwriting are back in play.

Under the new compromise, regulators won’t require a minimum down-payment (20% goes to 0%), and broad exemptions for banks and mortgage issuers to retain portions of these securities will be granted. (Ziebel and Ackerman “Softened Mortgage Rule Advances,” WSJ 6/11/2014). Policy memory seems short indeed. Whatever failures there have been in not modifying many of these defaulted mortgages, remedies for housing’s slow recovery ought not to center on creating bad incentives once again in mortgage underwriting.

Washington now apes the Bourbons of pre-revolutionary France. “They learned nothing and forgot nothing,” said Talleyrand, some forty-odd years after the catastrophe of the French Revolution. With ultimate policy discussions driven by electoral politics rather than sound economic analysis, it is truly remarkable that current-day academic macro economists continue to research the real causes of the Great Recession. Even if economists come to a widely accepted conclusion, it is highly doubtful that policy makers will care, much less alter government policies to prevent such debacles from again occurring. Plus ça change, plus c’est la même chose.

Today, the FOMC finally got around to initializing the “taper.” It reduced the purchase of mortgage related securities by five (5) billion dollars beginning in January 2014 and a like amount of Treasury securities. Purchases in January will drop to $35 billion of mortgage securities and $40 billion of long term Treasury securities, (a total of $75 billion) while the Fed’s balance sheet continues to grow by those amounts as principal repayments will also be re-invested and the policy of rolling over maturing Treasury securities is continued.

The Committee said that economic activity is expanding at a moderate pace and that there has been further improvement in labor market conditions. At the same time, there is no strong evidence of rising inflation or inflation expectations. Since inflation is still well below the Committee’s target of 2.0%, and unemployment at 7.0% is well above its target of 6.5%, there is no rush to raise the Federal Funds rate. In fact, based on the forecasts presented by the 17 members of the Committee, as measured inflation is well below what the Committee feels is appropriate, the Chairman indicated that the accommodative stance of monetary policy is likely to be continued well into 2015. The lengthening of forward guidance is a kind of Bernanke “Twist.”

The Twist

With the Funds rate at the zero bound, the usual tool of monetary policy (interest rate changes) is inoperative and that has given rise to Fed balance sheet expansion via these asset purchases and at the same time, a policy of forward guidance to markets that the Funds rate is unlikely to rise for a considerable period. Lessening the magnitude of asset purchase—and likely further drops in asset purchases in the forthcoming year—has created a need to re-assure debt markets that a return to normal, interest rate based monetary policy is a long way off. The Chairman stressed the dependency of this forward course on continuing improvements in macroeconomic data and at the same time allowed for a reversal of the “taper” if as yet unforeseen and untoward macroeconomic data begin to show up. Thus the magnitude of the taper and its future amounts is not set in stone. It is “data dependent.” In the Chairman and the Committee’s view, monetary policy is still quite accommodative, both from the point of view of continuing to add to the Fed’s balance sheet, but more importantly by the very size of that balance sheet that weighs down interest rate rises. The market seemed to accept these statements at face value, as there was very little upward drift at the longer end of the curve. The 10-year rate moved about 5 basis points, while the equity market boomed hugely. (S&P 500 up 1.66$%, Dow 30 up 1.84% and the NASDAQ -100 up 1.16%). In effect equity traders cheered then end of the “taper uncertainty.” The vote on the Committee for these policies was nearly unanimous, with the exception of Rosengren of the Boston Fed who felt the unemployment rate was “still elevated and well below the target.”

Fed Projections

The new Committee forecasts show improvement in the expected range of 2013 and 2014 growth rates, while the anticipated unemployment rates were lowered in each of the years stretching out to 2016. Expected inflation (as measured by the PCE index) was expected to fall slightly stabilizing at 1.7 to 2.0% in 2016. Core PCE was not expected to be much different (the lower end of the range was raised by 0.1% in 2014 (to 1.4) and again in 2016 (to 1.8). Each of the years 2013 through 2016 was lowered from the September projection.

BB’s Press Conference

As I watched his press conference, I was struck by his comfort and his mastery of the data, the policy debate and his complete ease in answering each of the questions. Bernanke is well known as a baseball fan. Today, he was definitely on his game.

The “twist” he has underscored is not written in stone and it is not a pair of handcuffs on the incoming Chairperson. Data dependency is still in play, however he noted that Janet Yellen was in concordance with the entire statement and the underlying measures that are reflected in the wording. Bernanke has one more meeting as Chairman, and if the data continue to improve (or at least not worsen), it is likely that more tapering will be voted in that meeting. What the future pace of tapering might be once Yellen assumes the Chair is speculative at this point. Furthermore, there will be new members of the Committee surely by February, probably including Stanley Fischer, the former Chairman of the Bank of Israel and Deputy Manager of the IMF. Fischer’s likely relevance is that he has reportedly commented that he is not terribly in favor of strong “forward guidance” as he finds that the predictive power of Central Banks is not sufficiently great, particularly at long intervals. What a Yellen-Fischer combination is likely to do to forward guidance and the pace of tapering will be the next uncertainty faced by equity and debt traders. Today, it was all cheering. Next year may be different

Perhaps the most interesting answer given by Bernanke in the press conference was in answer to the question of why it is with all the measures taken by the Fed that growth has not resumed its former long term tendency and even more important, that unemployment is still far in excess of recoveries in past recessions. Bernanke pointed out that first, fiscal policy has been part of the extreme headwinds, certainly over the past year and that other uncertainties such as the banking issues in Europe have not yet created the growth push of a normal recovery. He pointed out, for example, that in the prior recovery, State and Municipal employment rose about 600,000 while in this recovery, public employment was down some 400,000. A million less public jobs has made reducing the unemployment rate much more difficult. In his closing remarks, he reiterated the William Mcchesney Martin adage of the Fed being “independent within the Government,” reminding critical Congressmen that Congress writes the rules and the Fed is charged with carrying them out. Clearly, Bernanke meant to assuage some of the more vociferous advocates of “audit” and “control of the Fed” in saying that Congress certainly has the right to ask questions of the Fed and to set the ground rules for Fed targets. He did not get into the “audit the Fed” controversy but he clearly has still one more Hill to climb and surely hopes that it won’t be an ordeal

About the Author

Dr. Bernard E. Munk, principal of Munk Advisory Services, LLC, holds three degrees from the University of Chicago. Prior to entering the business world in 1969, he was a Fellow at the Brookings Institution; served on the economics faculties of the University of Illinois and the University of Michigan; was a consultant to the U.S. Agency for International Development, and was a visiting Professor at the Board of Governors of the Federal Reserve in Washington, D.C. Learn more